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Financing Distributor Acquisitions
Probably the greatest problem in growing a distribution business through acquisition is finding an appropriate company and successfully negotiating a deal. Once over this hurdle, the next challenge is to put in place the correct financing package.
Financing an acquisition is different for most every company. It all depends on the acquiring company size, amount of existing debt, assets that can be leveraged/collateralized and of course, the company's financial history. These factors will have an important effect in determining the amount of financing available and the ultimate cost of the acquisition.
In planning an acquisition there are many financing options which need to be considered:
- How much cash or cash equivalent can and will be put into a deal? Many buyers want to put little or no cash into a transaction and leverage 100%. In the past this was possible, however, since the financial industry collapse this has become unrealistic, if not impossible to accomplish. In the current environment, it is not unusual for the cash component to be at least 30% of the purchase price of a transaction. Therefore, when considering an acquisition make sure that there is a reasonable cash component available for the deal.
- Most distributors have an existing line of credit with their bank. This is most often a working capital line secured against receivables and inventory assets. In some cases this line may be well below its maximum availability. It is possible that the acquirer's funds might be available for acquisition financing. Lines of credit are available only after very thorough bank review. Therefore, it is most likely the bank has comfort with your financial condition/situation. Talk to your bank and find out if there are covenants that prevent the use of line of credit funds for acquisition. In your discussions with your bank, you may also determine that some of this line can be converted to another type of term loan. In some circumstances the target company is purchased by a new subsidiary that the buyer incorporates or organizes. This can shield the buyer's current business from the purchased business if your banker does not require cross-defaults. In this case, the line of credit is secured by the receivables and inventory purchased in the transaction and any future accounts receivable and inventory of the subsidiary after the purchase.
- Acquisitions are commonly financed in part with bank term loans. Consideration is given to the acquirer's assets and the assets to be purchased from the seller. The seller's bank loans need to be paid off and existing liens on the seller's assets need to be removed. There are no "always" in terms of debt financing, however, one can typically expect that 50-80% of a deal can be funded by bank term debt. Typically, term loans run five to seven years. The loan payments are most often amortized over the course of the loan, although in some cases smaller payments are permitted over the term with a balloon payment of the balance at the end of the term. The cost of secured term debt will vary as a function of the bank's borrowing costs plus some number of points above this. Depending on how the loan is negotiated and structured the rate can be either fixed or variable.
- In more complicated deals, where the buyer's financial position is less than "standard”, mezzanine capital is often utilized. This may also be used to fill a gap between the amount of equity provided by the acquirer in the deal and what the bank will lend. Mezzanine capital is always costlier than conventional bank loans because of the real and perceived risk associated with this type of lending. The spread tends to be consistent, however, the actual rate is a function of bank borrowing rates plus the premium required for the mezzanine debt. In general, mezzanine capital is not available from banks, but rather from specialized lenders who are privately financed. Mezzanine debt often comes with warrants to buy equity in the buyer at a nominal sum which warrants can be exercised in whole or in part over a period of time.
- In most, if not all, private transactions today there is a component of what is called "seller financing”. This most typically will take the form of seller provided term debt or some type of "earn out" structure. Seller financing is usually subordinated to other financing resources and often contains standstill provisions which prevent the seller from exercising any remedies in the event of any default under the seller financing without the permission of the senior lenders. If a buyer does not contribute sufficient equity to the deal, the senior lenders will treat the seller financing as equity. The hierarchy of lenders will most usually be the bank, followed by mezzanine type lenders followed by the seller. Therefore, seller financing holds the highest risk.
- Another frequently used financing structure is the SBA (Small Business Administration). In general, the SBA will underwrite the loan provided by a bank. If the borrower defaults; the bank will be compensated by the government, thereby leaving the SBA lender with limited risk in the deal.
One of the lending programs provided by the SBA is called the "504 Loan Program”. The following link takes you to the SBA web site that discusses the program in more detail. Link to SBA Web site.
In summary, from the web site: 504 Loans are typically structured with SBA providing 40% of the total project costs, a participating lender covering up to 50% of the total project costs, and the borrower contributing 10% of the project costs. Under certain circumstances, a borrower may be required to contribute up to 20% of the total project costs.
504 Loan example: Total 504 projects costs (Editor's note: applies in a similar way to an acquisition) for a $1,000,000 project may include the following (eligibility requirements apply to the 504 portion of the project as well as the participating lending portion): Building Purchase; Land; Renovation; Furniture and Equipment; Soft Costs.
Loan Structure: $500,000, 1st lien with bank (loan obtained from a private sector lender covering up to 50% of the total project cost); $400,000, 2nd lien with 504 loan, 20 year, fixed rate (loan obtained through a CDC*, funded through an SBA-guaranteed debenture, covering up to 40% of the total project cost; $100,000, borrower contribution (contribution from the borrower of at least 10% of the total project cost.)
* A Certified Development Company (CDC) is a nonprofit corporation that promotes economic development within its community through 504 Loans. CDCs are certified and regulated by the SBA, and work with SBA and participating lenders (typically banks) to provide financing to small businesses, which in turn, accomplishes the goal of community economic development.
VERY IMPORTANT: Although SBA lending is an option it is very important to obtain detailed information from a qualified SBA lender. In many banks there is an SBA department with very knowledgeable bankers.
One of the most important documents to have available before the borrowing process begins is a well-developed "plan”. If the acquired business is to be integrated with the current business, the plan must address the combination of the two. How do the integrated financials for the two businesses look? What changes are planned post acquisition which will work towards making the integration of the two entities successful? A good lender will give a lot of weight to a well thought out plan for the business.
It will be important to have accurate current and historic financial statements prepared by qualified accountants.
A distributor may need to be prepared to make "personal guarantees" for a loan. Most people cringe at the thought, however, this is a realistic part of the lending process today. Having a long-term banking relationship may offset this requirement, but one should be prepared nonetheless.
Don't start looking for a bank when you are about to make an acquisition. You should be developing a relationship with your current bank or with a new bank well in advance of a planned acquisition. Begin discussing your growth strategies and how an acquisition could help you achieve your goals with your bank. Bankers are conservative by nature and are much more receptive when they are not surprised by their customers. It can take as long to get a lender comfortable with a deal as it can to get a seller to agree to a deal.
Growing your distribution business through acquisition can be a time-consuming and difficult process. However, an appropriate fit will accelerate the growth of your company, improve your competitive position and potentially reduce certain risks, such as customer concentration. Very often a strategic acquisition will not only add new customers, but it can add management talent, new products and an expanded supplier base.
Thanks to Ken Yager, Senior Managing Director at GlassRatner (KYager@GlassRatner.com) and Terry Kennedy of the Kennedy Law Group (TPKennedy@TPKLawGroup.com) for their inputs and insights in putting this article together. Both have strong M&A backgrounds and provide a valuable resource for any deal team.
The Distributor Board M&A practice works with distributors to achieve growth through acquisition goals. Contact M. Jay Heilbrunn, a Partner of The Distributor Board to discuss an appropriate process for your company.